My SmallTrades portfolio holds stocks and four classes of exchange-traded index funds (ETFs).
The goal is to outperform a reputable benchmark, the Standard & Poors 500 Total Return Index, on a sustained basis. The ETFs are diversified and rebalanced in order to partially offset the losses of a declining market. A small group of stocks are used to boost the investment returns.
In FY2016 the portfolio’s market value increased by 8.3% due to a 9.1% gain in stock value and 8.1% gain in ETF value. Charts 2 and 3 illustrate the nominal (solid lines) and real (dashed lines) growth in unit value for shares of the portfolio, ETF group, stock group, and benchmark. The number of shares for each entity was the initial market value divided by $1 of U.S. currency. Assume that the initial unit value of $1 was a real value unaffected by inflation.
Chart 2 shows the pattern of unit-value growth for the benchmark (black lines) and portfolio (blue lines) since December 31, 2007.
The unit value of both entities declined in year 2008 and began to recover in year 2009. The benchmark (black lines) recovered in year 2011 while the portfolio (blue lines) is still struggling to recover [notes 1,2]. The effect of inflation was to devalue real growth (broken lines) compared to nominal growth (solid lines). The real unit value signifies the purchasing power of the investment. The investment has greater purchasing power than uninvested money when the real unit value exceeds $1.
Chart 3 shows the result of implementing the current investment goal [note 2] with a small group of stocks (red lines) and large group of ETFs (blue lines). In chart 3, the initial unit value was re-calculated on December 31, 2013.
Since 2013 the stock group clearly outperformed the benchmark (black lines) and ETF group. The success of the Stock group is attributed to investing in ‘good’ companies for the long term [note 3].
Chart 4 shows the market sector and market cap diversity of the stock group defined in chart 1.
Several stock trades were made during FY2016 to improve the chance for success.
- Alibaba Group (BABA), for 10% capital gain, to exit the Chinese market.
- Geely Automobile (GELYF), for 14% capital gain, to exit the Chinese market.
- Corning Inc. (GLW) for no gain.
- iRobot Corp. (IRBT) for 10% capital gain.
- ITC Holdings (ITC) for 14% capital gain, due to the stock’s delisting.
- Stericycle (SRCL) for 34% capital loss, to stop further loss.
- Biogen (BIIB), an innovative biotechnology firm.
- Cal-Maine (CALM), a leading producer of shelled eggs.
- Express Scripts Holdings (ESRX), a large mail order pharmacy
- Royal Bank of Canada (RY), a well-capitalized bank.
Chart 5 shows the distribution of asset classes among the ETFs. All asset classes drifted from an allocation plan of 30% stocks, 30% REITs, 20% bonds, and 20% gold [note 4].
The SmallTrades portfolio’s primary strategy for risk management is holding a large group of diversified ETFs that are rebalanced to correct a significant allocation error. In theory, a significant drift of asset classes occurs when one asset class surpasses a 28% allocation error. At the end of FY2016, the existing allocation errors (blue bars) were within 24% error limits (red dashed lines) as illustrated in Chart 6.
Chart 6 reflects the portfolio’s response to an incline in equity markets compared to decline of the bond and gold markets. History has shown that a decline in equity markets tends to be offset by a rise in the bond and gold markets.
Plan for FY2017
The SmallTades portfolio will continue to be actively managed for long term success. The ETFs will be rebalanced anytime there’s a 24% allocation error or a modification of the ETF holdings. I would like to own fewer large cap stocks in favor of small- and mid-cap stocks issued by good companies with potential growth of earnings.
- On 12/31/2007, the portfolio held a group of actively managed mutual funds in a tax-deferred Roth account. Since then there have been no cash deposits or withdrawals and the portfolio still resides in the Roth account. During 2007-2010 the mutual funds were traded for stocks in an attempt to earn a 30% annual return by process of turning over short term ‘winners’. Several mistakes led to a big loss: A) after a couple of short term capital gains from Lehman Brothers Inc., I ignored the dangers of that company’s large debt and lost $45,000 during its decline to bankruptcy. B) substantial long term profits from good companies were lost by selling holdings for short term profits. I was trying to earn a quick 30% annual rate of return and immediately re-invest in the next set of winners. It was too difficult to identify the next winners. C) day trading also prevented a 30% return. It was a game of chance that I played without a strategy and I was fortunate to break even. D) a trial of investing in leveraged ETFs resulted in losses due to negative compounding. Leveraged ETFs were very high-risk investments that I made without a sound strategy.
- I abandoned the goal of a 30% annual rate of return in 2012 by adopting a more realistic, but still aggressive, goal of outperforming the benchmark. That same year, I changed my investment strategy to that of holding a mixed portfolio of 80% broad market ETFs and 20% stocks for the long term.
- ‘Good’ companies attract and retain investors for many years. I search for profitable companies with growth potential that are undervalued by the stock market. My search methods include reading reputable sources of business news, participating in investment club discussions, using stock screeners, and attending investor conferences. I include and exclude stocks by reading analyst reports, financial statments, SEC filings, and market analyses. Valuation critieria help me decide if the stock price is worth paying.
- Prior to March, 2016, five ETFs were allocated to four asset classes with each asset class holding 25% of the combined market value. Since I don’t depend on making withdrawals from the SmallTrades Portfolio, I increased my exposure to global stocks and REITs by decreasing my exposures to investment-grade bonds and gold bullion. The new allocation rule was 30% stocks, 30% REITs, 20% bonds, and 20% gold. Any drift in allocation to a 24% error will be rebalanced.
Copyright © 2017 Douglas R. Knight